Learning from Episodes of Systematic Shocks: Demonetization in India

As COVID-19 pandemic sweeps through nearly all the economies across the globe and causes major devasting effects, can we draw some lessons from system-wide, non-economic initiated shocks in the past?  A unique episode in India provides one such opportunity.

On November 8th, 2016, the government of India unexpectedly declared 86% of the existing currency in circulation illegal tender. Since a significant proportion of transactions in India is mitigated by cash, such policy essentially temporarily halted a significant portion of economic activities. A recent study led by macroeconomists Gabriel Chodorow-Reich and Gita Gopinath evaluates the short-term impacts of such policy.

Although the negative impacts of the demonetization were mostly transitory, the authors find a contraction in aggregate employment and nightlight-based output due to the cash shortage of at least 2 percentage points in the fourth quarter of 2016 comparing to the counterfactual path. Taking advantage of district-level variations in the speed of recovery as the Reserve Bank of India re-stock regional currency chests with new, legal notes, the authors conclude that districts experienced more severe demonetization shock suffered from a greater reduction in aggregate employment and output, exhibited greater demand for ATM withdraws and bank credits. The strong impacts on real economic outputs firmly reject money neutrality and shed light on why cash matters, i.e. households need cash to pay for day-to-day expenditures and use cash to engage in tax evasion.

Despite the significant costs, demonetization, however, did pave the way for the spread of digital technology. To be precise, districts that were hit harder by the shock showed higher adoption rates of digital payments as people tried to mitigate the challenge brought by a lack of cash. In fact, one of the original motivations for the policy was to promote the adoption of financial services which help formalize the economy to expand the tax base. Related research by Crouzet, Gupta, and Mezzanotti (2019) using data from Paytm find that areas that are more exposed to the shock saw a greater increase in digital payments. However, they also find that such an increase was more pronounced in areas that are more urbanized and among salaried workers, suggesting that proper infrastructure is needed for digital services to spread.

Wherever there are challenges, opportunities arise. On the one hand, such systematic shocks could be major turning points for pushing society towards the adoption of new technology and norms for building a more resilient socioeconomic system.

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